As companies and financial institutions grow more dependent on the global economy, the volatility of currency exchange rates, interest rates, and market fluctuations creates significant risks. Failure to properly quantify and manage risk can result in disasters such as the failure of Barings ING. To help manage risks, companies can trade derivative instruments to selectively transfer risk to other parties in exchange for sufficient consideration.
A derivative is a security that derives its value from another underlying security. Derivatives also serve as risk-shifting devices. Initially, they were used to reduce exposure to changes in independent factors such as foreign exchange rates and interest rates. More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific risk characteristic of a security.
Derivative markets play an increasingly important role in contemporary financial markets, primarily through risk management. Derivative securities provide a mechanism through which investors, corporations, and countries can effectively hedge themselves against financial risks. Hedging financial risks is similar to purchasing insurance; hedging provides insurance against the adverse effect of variables over which businesses or countries have no control.
Many times, entities such as corporations enter into transactions that are based on a floating rate, interest, or currency. In order to hedge the volatility of these securities, the entity will enter into another deal with a financial institution that will take the risk from them, at a cost, by providing a fixed rate. Both the interest rate and foreign exchange rate derivatives lock in a fixed rate/price for the particular transaction one holds.
For example, Alan loans Bob $100 dollars on a floating interest rate. The rate is currently at 7%. Bob calls his bank and says, “I am afraid that interest rates will rise. Let us say I pay you 7% and you pay my loan to Alan at the current floating rate.” If rates go down, the bank makes the money on the spread (the difference between the 7% float rate and the new lower rate) and Bob is borrowing at a higher rate. If rates rise however, then the bank loses money and Bob is borrowing at a lower rate. Banks usually charge a risk/service fee, in addition, to compensate for the additional risk.
Consider another example: If ABC, an American company, expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with Bank A to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, Bank A is obligated to pay ABC the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, ABC has shifted the risk of exchange rate movement to Bank A.
The financial markets increasingly have become subject to greater “swings” in interest rate movements than in past decades. As a result, financial derivatives have also appealed to corporate treasurers who wish to take advantage of favorable interest rates in the management of corporate debt without the expense of issuing new debt securities. For example, if a corporation has issued long term debt with an interest rate of 7 percent and current interest rates are 5 percent, the corporate treasurer may choose to exchange (i.e., swap) interest rate payments on the long term debt for a floating interest rate, without disturbing the underlying principal amount of the debt itself.
In order to manage risk, financial institutions have implemented quantitative applications to measure the financial risks of trades. Calculating the risks associated with complex derivative contracts can be very difficult, requiring estimates of interest rates, exchange rates, and market prices at the maturity date, which may be twenty to thirty years in the future. To make estimates of risk, various statistical and probabilistic techniques are used. These systems, called Pre-Settlement Exposure Servers (PSE Servers) are commonly known in the art.
PSE Servers simulate market conditions over the life of the derivative contracts to determine the exposure profile representing the worst case scenario within a 97.7% confidence interval, or approximately two standard deviations. This exposure profile is calculated to give current estimates of future liabilities. As market conditions fluctuate from day to day or intra-day, the calculated exposure profile changes; however, these changes are not always due to market fluctuations, they are sometimes due to errors in the input data.
In the past, input data errors have been manually detected by users; however, since the quantity of input data is now so large, it is impossible for users to detect and correct all of the errors. Users are most likely to detect errors in the input data that cause a significant change in the exposure profile.
The present invention seeks to automatically detect errors in input data to the PSE Server using an information theory technique known as Content Analysis. Content Analysis, based on information theory, attempts to look for sweeping changes or statistically significant trends in data suggestive of error. If statistically significant changes are detected, users can be alerted that one or more errors in the input data is likely. This prevents invalid data from skewing the resulting exposure profiles, providing more accurate estimations of possible exposure.